The Benefits of Leverage in Spot Gold Trading

The Benefits of Leverage in Spot Gold Trading

One of the key steps in making a spot gold trade is determining a trade size, because selecting the correct trade size is critical to effective risk management.

How much spot gold you can trade depends on how much money you have in your trading account as well as the online trading firm’s leverage and margin requirements.

Typically, online forex trading firms will allow leverage of 50:1 for spot gold. If you can trade spot gold on a margin of 50:1, for every $1 you have in your account you have $50 in buying and selling power for spot-gold trading. In other words, a $5,000 account can trade up to $250,000.

Margin is the amount of money you must have in your trading account to make a particular trade. At 50:1 leverage, your margin requirement would be 0.02, or 2%. This means you must have a minimum cash balance of 2% of the total value of your spot gold positions. If you fall below 2%, your trade may be closed automatically, or, as it is referred to in trading language, liquidated.

Let’s look at an example of how leverage works. Let’s say you would like to trade one lot of spot gold (which, as we have mentioned in other articles, equals 10 troy ounces) at $820.50. So, your total trade size would be 10 X $820.50, or $8,205. Since your margin requirement is 2% of your trade size, the amount of cash you would need in your account would be $8,205 x 0.02, or $164.10. If your account balance falls below this level, your trade will be automatically closed.

Leverage is what makes online spot-gold trading an excellent opportunity for beginning gold traders, who may not have large cash balances. Leverage increases your buying and selling power and lets you participate in a market that may otherwise be cost-prohibitive. In the example above, for example, 50:1 leverage gave you the ability to trade 10 ounces of spot gold at $820.50—a value of $8,205—with just $164.10.

Of course, it is important to keep in mind that increasing leverage also increases risk. You could make greater profits with a leveraged account, but you could also experience greater losses.

Risks and Rewards of Leverage in Gold and Silver Forex Trading

One of the most important steps in online gold and silver trading in the Forex market is to select the best possible trade size or lot. Trade size determines the profit levels you can achieve from the trade. How much trade size you can order depends on the funds you have on your account and also the leverage and margin allowed by the online forex-trading broker.

Normally online Forex brokers allow leverage of 50:1 for gold and silver trading. US citizens, however, are not offered leveraged gold and silver trading since Dod-Frank Act passed in 2011 prohibits leverage trading in commodities. Nonetheless, leverage trading is allowed for currencies that are highly correlated to gold like Australian and New Zealand dollars.

Leverage offers tremendous advantage to traders to earn windfall returns by trading in large trade size with their small investments. Without leverage traders can only invest in small lots that result in negligible profits. Leverage increases your buying power and amplifies the chances of earning greater returns on investment. Through leverage traders can amplify their profits to thousands of dollar.

For instance, if the online Forex trader allows you a leverage of 50:1, you can order up to $250,000 with just $5,000 in your account. You just have to maintain 2% (1/50) margin of the total value of the order size to continue trading in the Forex market. So, if you order $150,000 out of the total leverage allowed, you must maintain $3000 (150,000*2%) in your account to continue trading in Forex using leverage otherwise the trade will be closed automatically.

Let’s say that your $150,000 lot size currency pair moves in a favorable direction for 20 pips. This means that your profit will be $300 (150,000*0.0020) from the trade. It you avail the full leverage of $250,000, you can earn profit of $500 (250,000*0.0020) form the favorable movement in currency values. In contrast, without leverage your profit from the trade would just have been $10 (5,000*0.020). So, using leverage you amplify your profits by as much as 98% thus earning great amount of profit from the forex trade.

Dangers of Leverage Trading – Greater Rewards = Greater Risks

However, you must remember that leverage trading in the Forex market entails certain risks. You must have heard of the cliché that with great power comes great responsibility. This is especially true for using leverage to trade in the Forex market.

Beginner traders especially make the mistake of using leverage with no regard for the risk attached with leverage trading. Using leverage to trade in Forex can exponentially increase your chance of earning profits, but it can also increase the chance of earning losses in case of unfavorable trade. You could easily suffer a loss of the above amount in case of unfavorable movement in currency values. The higher the leverage more is the chance of earning a loss from the trade.

If in the example given above the leverage was 100:1 rather than 50:1, the loss amount could have been even greater in case of unfavorable price movement. With 100:1 leverage you can order $500,000 lot size with $5,000 in the account. In case of unfavorable price movement of 20 pips, the loss you would have to bear equates to $1,000 (500,000*0.0020). This amount will be deducted from your account, which you have to add again to you account otherwise the trade will close.

Most experts recommend that traders should not utilize more than 50:1 leverage to trade in the Forex market. You should ideally utilize 20:1 or 10:1 leverage to protect your savings from adverse price movements. This means that in case of unfavorable price movement, you would lose less amount of your investment in case of a loss.

Consider the same trader above that has $5,000 in his account instead of using leverage of 100:1 or 50:1 utilized 20:1 leverage. In case of unfavorable price movement, the loss amount would be $20 (10,000*0.020) only significantly reducing the loss amount.

The best risk management advice in using leverage in the Forex market is that you should use it judiciously. If the markets are generally stable, you can utilize higher leverage (not more than 100:1) to gain from the trade. Contrarily, if the markets are fluctuating and unstable, you should use leverage sparingly.

Apart from condition of the market, you should also consider the spread charged by the broker when using leverage to trade in the Forex market. Generally higher spread means that the currency values have to increase by higher pips to gain from the trade.

In addition, the more leverage you use the higher is the spread you have to pay to the online trading broker. Leverage in a way increases the cost of transacting in the Forex market. A simple example can help you in understanding how leverage impacts cost of Forex trade.

Suppose you open an account with $5,000 and decide to buy a currency pair having a spread of 2.5 pips. With 100:1 leverage, you can trade in lot size of value $500,000. However, the spread of 2.5 pips means that just to break even you have to earn a profit of $125 from the trade. With lower leverage, the amount of profit you have to earn to break even is considerably lower.

Summary

In light of the discussion above it can be said that using leverage to trade in Forex entails both risks and rewards. Higher leverage increases the chance of earning higher profit, but it also increases the risk of loss for the trade. Therefore, it is extremely essential that you use leverage with caution while trading in the Forex market.

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